Debt ceiling: Capital vs. the Capitol

Until last week, that was the reaction from market types, who couldn’t believe that Washington pols would play a full-out game of political chicken with an economy still struggling to rouse itself out of recession. An economy with unemployment topping 9 percent that added only 18,000 new workers onto payrolls in its last jobs report; an economy where corporations clutch on to nearly $2 trillion in cash piles, while gross domestic product growth tracks at a worse than tepid 1.3 percent and the housing market continues to sputter. An economy facing not just a short-term setback, but a long-term stall.

Story Continued Below

Even now, just days shy of the Aug. 2 deadline, almost no one in the financial markets will admit the possibility that a debt deal might not get done.

During the past three decades, the debt limit lifts have gotten shorter and more frequent – in 10 of the last 30 years the U.S. government has operated under legislation lasting less than a year. Surely Congress will find a way to pass one more of these short-term fixes — even if it can’t come to a long-term deal?

But it might not. For reasons that market folks understand: incentives. Investors answer to those who hire them to manage their capital. And Washington politicians respond to those who send them to the Capitol.

The vote offers an irresistible platform for House members who oppose the debt limit lifting and want to send a message to Washington — and the country — that enough is enough. The debate gives them a megaphone, and the chance to show the voters who elect them every two years that they mean business.

If their individual vote eventually leads the country toward collective economic destruction, they can answer that they were representing the voices of those who elected them. They are, in their view, responding rationally to the demands of their employers — in this case their constituents.

For market players, the idea that unhappy constituents, fed up with government spending, would determine the fate of a vote on a topic as both arcane and critical as the debt ceiling is ludicrous. Of course, these same folks found it inconceivable that the House would vote “no” on the TARP in 2008 — until it did.

Investors believe in rational responses to rational incentives. It is beyond irrational to them that anyone would tamper with the sacredness of Treasury bonds, the ultimate ‘risk-free’ asset, the baseline against which all other market risk is judged.